BUDGETING The Planning Process All organisations have their objectives.

Some of the objectives may not be expressed in accounting terms for example objectives to improve the welfare of the staff or to improve the impact on the local environment. However, in this chapter the emphasis is on objectives usually expressed in quantitative terms eg. increase in market share, profit growth, increase in the asset value etc which they wish to achieve. There are three levels of planning - corporate long term planning, medium term planning and annual planning or budgeting. The annual budgets are steps along the way to achieve the long-range plan of the organisation. To ensure that the objectives are achieved plans or budgets must be prepared. Definition: A budget is a financial or quantitative interpretation prior to a defined period of time, of a policy to be pursued for that period, to attain a given objective.

Budgets are part of the planning and control process. They help to define the objectives of the organisation. Budgeting is probably the most important contribution that the accounting department makes to the role of management. The accountant draws up a plan which integrates the various functional areas of the business. Control is exercised by firstly, delegating responsibility to departmental managers for the attainment of the budgets and then the regular comparison of the actual results with the planned outcomes. Budgets assists an organisation to plan and control profitability to plan and control production resources to plan and control capital expenditure to plan and control finance An organisation which engages in budgeting can obtain the benefits of better planning and awareness of what has to be achieved greater coordination of the different functional areas better communication with staff contributing to the targets to tbe set motivation of the staff with staff assigned their responsibilities

 efficient and effective use of scarce resources and an awareness of costconsciousness

Administration of the budget. The administration of the budget is the responsibility of the budget officer who is usually the accountant . The accountant works in conjunction with the budget committee comprised of the departmental management. Senior management outline the broad strategic objectives of the organisation and communicate these to the functional managers. The budget committee identifies the key budget factor which determines what acts as a constraint on the organisations activities. This key budget factor decides the key budget ie. the one which sets the objectives for the subordinate budget. The subordinate budgets are constructed by asking the questions - when are the goods to be sold, where are the goods to be sold and how are the goods to be produced.It may be the sales volume which drives the other subsidiary budgets. For instance, if the sales department forecasts the annual sales at 20,000 units then the production budget must be integrated with this figure. Alternatively, productive capacity may be the key budget factor . The company may have the capacity to produce only 18,000 units a year so this figure sets the objectives for the other budgets. The accountant helps the managers to set the budgets by providing information as required. Sales forecasting may proceed by means of statistical methods which are based on economic indicators or by carrying out an internal forecast by canvassing the sales staff. The current sales level, past trends, market research can provide useful information. On receipt of the various budgets the accountant notifies managers of revisions to their budget. Once the accountant and the committee agree the master budget which is a forecasted profit and loss account and balance sheet can be drawn up. In terms of control the accountant is responsible for the regular monitoring of the budgets, for reporting back to the budget committee regularly( daily,weekly or monthly basis) through variance reports and for revising the budgets if necessary. Preparing budgets Example The budgeted sales of Magee Engineering Lt. for 19x0 is as follows: Product Sales units Unit selling price

Dag Mag Pag

20,000 18,000 15,000

25 20 22

The opening stocks at the beginning of the year 19x0 Product Product units Component Dag 3,000 A Mag 3,000 B Pag 2,000 C D E

Part units 40,000 50,000 60,000 40,000 10,000

The marketing director intends to run a marketing campaign towards the end of 19x0 and has requested that product unit stocks should be increased at the end of 19x0 above the commencement stocks by the following Dag increased by 20% Mag increased by 50% Pag increased by 20% The purchasing director has requested that all components part stocks be reduced by 20% at the end of 19x0 because of improved delivery times from suppliers. The product material specification and component cost for each of the products are as follows:

Product

Component part Part cost (each) Component parts per product

A 50p

B 35p

C 60p

D 55p

E 1.0

Dag Mag Pag

3 2 5

4 3 2

6 4 3

2 2 3

1 1 1

The newly appointed managing director asks you to prepare the following budgets and to explain the linkage between them. 1 2 3 4 Sales budget in product units and value Production budget in product units Material usage budget in component parts. Materials purchase budget in component parts and value.

1. Sales Budget 19x0 Product Dag Mag Pag Units 20,000 18,000 15,000 -------53,000 -------Price 25 20 22 Total sales 500,000 360,000 330,000 -----------1,190,000 ------------

Comment: the sales budget is computed from the sales information stated, the budget shows the the individual product sales units,sales value and total sales value. The budgeted sales for 19x0 are 53,000 units with a total sales value of 1,190,000.

Production budget 19x0 Dag 20,000 3,600 -------23,000 3,000 ------20,600 -------Mag 18,000 4,500 -------22,500 3,000 -------19,500 -------Pag 15,000 2,400 -------17,400 3,000 -------15,400 --------

Sales units (from the sales budget) Add closing stock

Less opening stock Budgeted output

Comment: the production budget is the required production to meet sales budget requirements and changes in stocks, thus since closing stock requirements are greater than opening stocks then production must be increased to cope with required production for sales and increased closing stock requirements. 3. Materials Usage Budget 19x0 (Component usage) Product Dag Mag Pag Prod. units 20,600 19,500 15,400 -------55,500 -------A 61,800 39,000 77,000 -------177,000 --------B 82,400 58,500 30,800 -------30,800 -------C 123,600 78,000 46,200 -------171,700 --------D 41,200 39,000 46,200 -------247,800 --------E 20,600 19,500 15,400 -------55,500 --------

Comment: the material usage budget is the component usage. This is simply the production units from the production budget equated to the component

specification in each production unit eg. material usage of compont A is the total usage of component A in Dag, Mag and Pag.

4. The Material Purchase Budget 19x0 Component A B C D Material usage budget 177,800 171,700 247,800 126,400 Closing stock 32,000 40,000 48,000 32,000 -----------------------------------209,800 211,700 295,800 158,400 Opening stock 40,000 50,000 60,000 40,000 --------------------------------169,800 161,700 235,800 118,400 Price per component 50p 35p 60p 55p 84,900 56,595 141,480 65,120

E 55,500 8,000 ---------63,500 10,000 --------53,500 1.00 53,500

Comment: The material purchase budget gives the cost and quantity of each component that is needed to be purchased and the overall cost of all five components. This budget is based on the material usage budget adjusted for oppening and closing stocks.

Cash Budgets

The cash budget shows the forecasted cash inflows and outflows of a business and measure the estimated balance or deficit of cashfor a particular period. The advantages of planning for cash resources is essential since a business cannot survive without cash. Advantages: The cash budget ensures adequate cash planning and control

(a)

Cash deficits are revealed and management can respond by taking appropriate action. Remedial action can be taken by injecting more capital into the business, by borrowing, by examining their credit policy or by deferring capital expenditure. Cash surpluses are indicated and once recognised need to be managed. Management can invest cash in the short-term, or avail of trade discounts by bulk purchasing materials or finance capital projects.

(b)

Example The London Toy Co. Ltd. commenced operations in December 19x0 with a capital of 600,000 which was raised through an issue of 600,000 ordinary shares of 1 each. The proceeds of the share issue were paid into the company bank account. During the course of December a number of transactions took place and these are summarized below. Cash summary December 19x0 Proceeds from share issue Less Leasehold premises (20 years) Plant (est. life 10 years) Equipment (est. life 10 years) Tools Raw materials Cash balance available 300,000 80,000 160,000 20,000 10,000 --------- 600,000

570,000 ---------30,000 ======

You are given the following additional information.

(a)

Sales are budgeted as follows: 80,000 in January; 160,000 in February and 240,000 in subsequent months. Fifty per cent of the sales will be cash sales and the other fifty per cent credit sales. The period of credit extended to customes will be one month. The cost of raw materials will amount to 40% of the sales revenue. Half the materials cost for any one month will be paid in cash; the other half will be paid for during the month of purchase. The company intends to keep a stock of raw materials of 10,000 throughout the year. Direct wages will be incurred at the rate of 50,000 per month. No time lag is expected here.

(b)

(c)

(d)

Other expenses- depreciation on premises, plant and equipment will be calculated on a straight-line basis. The tools will be re-valued annually and it is expected that annual losses will amount to 20 per cent. All other expenses will be incurred at the rate of 40,000 per month - the time lag here will be one month. You are asked to prepare the companys Cash budget, a budgeted Profit and Loss account for the first six months of operations and a budgeted Balance Sheet as at 30 June 19x1. Jan 000 30 40 -----70 -----Feb 000 4 80 40 -----124 -----Mar 000 (14) 120 80 -----186 ----Apr 000 16 120 120 -----256 ----May 000 70 120 120 ------310 -----Jun 000 124 120 120 ------364 -----Memo 000

Opening balance Cash inflow Cash sales Credit sales Total

120Dr

Cash outflow Raw mats. -cash Raw mat. -credit Direct wages Other expenses Total Closing balance

16 50 -----66 -----4 ===

32 16 50 40 -----138 -----(14) ===

48 32 50 40 -----170 -----16 ===

48 48 50 40 -----186 -----70 ===

48 48 50 40 -----186 -----124 ===

48 48 50 40 -----186 -----178 ===

48Cr 40Cr

Students should note that: (a) (b) Depreciation never appears in a cash budget as it is a non-cash expense. In respect to credit transactions time lags have to be built into the cash budget

It is useful to have a memo column to record items which will appear in the balance sheet if required.

Budgeted Profit and Loss Account for six months ending 30 June 19x1 480,000 300,000 --------- Sales 780,000 420,000 ---------1,200,000 ======= Operating profit 7,500 4,000 8,000 2,000 ------ 1,200,000

Cost of sales Direct wages Operating profit

Depreciation Premises Plant Equipment Tools Other expenses Net profit

----------1,200,000 ======= 420,000

21,500 240,000 158,500 ---------420,000 ======

---------420,000 ======

The profit and loss account is prepared on an accruals basis unlike the cash budget which is prepared on a receipts and payments basis. Also, depreciation appears as an expense in the profit and loss account. Budgeted Balance Sheet as at 30 June 19x1

Authorised and Issued Capital 600,000 Ord. shares 1 each Reserves Profit and loss account

Fixed assets 600,000 Premises Plant 158,500 Equipment Tools

Cost 300,000 80,000 160,000 20,000 --------560,000 ---------

Dep. 7,500 4,000 8,000 2,000 -------21,500 ---------

NBV 292,500 76,000 152,000 18,000 --------538,500

Current Liabilities Creditors Accrued expenses

Current assets 48,000 Materials 40,000 Debtors Cash -------846,000 ======

10,000 120,000 178,000 ----------

308,000 ---------846,000 =====

Budgeted debtors, creditors and cash balance is obtained from the cash budget. Details of fixed assets can be obtained from the capital expenditure budget. Information about share capital, debentures etc. can also be obtained from the previous balance sheet. Budgeting - the Control Process Definition: Budgetary control is the establishment of departmental budgets relating the responsibilities of executives and the continuous comparison of actual with budgeted results, either to secure by individual action the objective of that policy or to provide a basis for its revision. The budget itself is merely a plan on paper which of itself will not be effective unless there is a system of control which can monitor the organisations progress to achieving the objectives. By means of comparing actual results with the budgets and identifying any differences (variances) which occur management can take remedial action or revise the budget if necessary. The annual budgets are broken down into months so the comparison is performed regularly and results in a budget report ipresented to the departmental managers. To ensure that management are not overburdened with accounting data exception reports may be furnished. These reports identify only significant variances that require managements attention and consequently are more user friendly and should encourage an appropriate managerial response.

Personnel Dept Cost Descripti code on 010 Superviso rs salary Flexible Budgeting

Monthly Budget Report February Budget Actual Variance Budget Actual 58,000 65,000 7,000 (A) 116,00 0 125,0 00

Variance 9,000 (A)

Up to this point the budget has been fixed. This is quite appropriate for planning purposes but of little use for control purposes. The fixed budget does not respond to the actual level of activity. When organisations compile the master budget it is based on a certain level of output and sales. In most instances, the company may find that this operating level is not set at the actual level of activity. Indeed most organisations find it difficult to forecast the actual level of activity eg. there may be a seasonal characteristic to the company trading. In such cases the business may find it more useful to prepare flexible budgets. A flexible budget is designed to change in accordance with the level of activity attained (CIMA) A fixed budget is not designed to change with different levels of activity. It does not allow for the pre-determination of costs and revenues at different levels of output which would facilitate comparison with actual costs and the identification of variances. A flexible budget is designed to recognise cost behaviour at different levels of output so actual results can be compared with the expected results and the computation of variances and variance analysis is made possible.

Example: A company produces garden furniture which experiences fluctuations in production levels because of its seasonal nature. The following costs for the budgeted level of activity of 20,000 units and the actual production costs fpr the period are given. Budget Costs (20,000 units) 21,000 1,000 3,000 10,000 5,000 -------40,000 -------Actual costs incurred (17,600 units) 20,000 980 2,680 10,000 6,000 -------39600 --------

Materials - variable Labour - variable Maintenance - variable Fixed production costs Selling costs - fixed

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During the relevant period, the actual number of units produced was 17,600. You are required to prepare a budget flexed at the actual level of activity. In preparing the flexed budgets it is important to identify fixed and variable costs to forecast costs at different levels of activity.

Actual costs 20,000 980 2,680 10,000 6,000 ------39,660 --------

Materials Labour Maintenance Fixed productioon costs Selling costs

Flexed budget (17,600 units) 18,480 880 2,640 10,000 5,000 ------5,000 -------

Variance 1,520 (A) 100 (A) 40 (A) ----1,000 (A) ----------2,660 ----------

The variance report highlights that in respect to actual materials, labour, maintenance and selling costs, these are higher than expected. Management can examine and analyse the variances and take appropriate action. Many businesses prepare fixed budgets for departments where expenditure may be more predictable such as the administration department. Flexible budgets can be compiled for those departments whose expenditure is closely linked to the level of operations such as the production department.

The Human Element in Budgeting So far the emphasis has been on the technical aspects of budgeting viz. the preparation and administration of budgets. However, the behavioural context deserves mention. One of the main components of budgeting is control which is all about altering the behaviour of the human resources in the organisation. Consequently, there may be some staff who regard budgets as a constraint on their freedom and may try to subvert the effectiveness of the budget. How can senior management ensure that the budgeting system can be most effective?

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Research findings assert that managers prefer to work towards achieving objectives which motivate them. It appears that motivation is the glue which holds the budgeting and control systems together so creating this motivation is the key. There appear to be a number of factors involved. 1 Budgets (targets) should be set at a level which are stringent and challenging but attainable. If set too high to be unattainable the staff may be demoralised and may not try to achieve the targets. Departmental managers in consultation with their staff should be permitted to participate in the setting of their budgets by so doing they will have ownership of them and will strive to attain them. Participation clarifies responsibilities, increases communication throughout the organisation and can help to promote line-staff relations. However, it is well to acknowledge possible dysfunctional behaviour as a consequence of participation in budgetsetting such as budgetary padding or budgetary slack. It may serve the manager to build slack into the budget ie. to have a pad between the formal plan and the expected actual results so that they have a cushion in case unanticipated events cause their performance to decline. Since budgets tend to be used as a management performance criteria there should be a reward system in place. Too often budgets are used as a mechanism to focus on poor performance so is it any wonder that the staff have negative feeling about them. Overemphasis on performance/variance reports may encourage negative attitudes to budgeting. Hopwood referred to the budget constrained style of management with performance in meeting the budget as the main criteria.

The organisation should be concerned with other management performance criteria such as concern with quality, good industrial relations, cooperation with colleagues etc. There are significant benefits for organisations which engage in budgeting. 1 Budgeting forces management to focus on the future, to consider the dynamics of the external environment and identify the potential opportunities and threats. In the process of preparing the budgets managers are compelled to coordinate the various activities of the organisation and to be less departmental minded and to be more company minded. It tends to encourage communication throughout the organisation. Staff are aware of what they are expected to achieve and regular budget reports and budget meetings keep them informed.

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By assigning managerial responsibility for the attainment of the budgets and the regular comparison of actual results and expected outcomes individual managerial performance can be ascertained. Research has indicated the role budgets have in motivating managers to achieve the companys objectives. Good performance can lead to career advancement so the managers desire to be successful is linked to the success of the company.

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